Bipartisan JOBS Act Provides Significant Reforms to Public and Private Securities Offerings

President Obama is expected to sign into law the Jumpstart Our Business Startups (JOBS) Act (H.R. 3606), which both the U.S. Senate and U.S. House of Representatives passed by large bipartisan majorities. Although it is questionable whether the JOBS Act will create any new jobs, the law will certainly have a significant impact on the regulation of public offerings and private placements of securities.

The JOBS Act is based in part on the IPO Task Force Report issued in October 2011, which identified a growth crisis in the market for initial public offerings. The IPO Task Force Report found that the number of IPOs—and particularly smaller IPOs—had dropped dramatically from their peak in the late 1990s and recommended an "on-ramp" to encourage new IPOs by using phased-in reporting requirements. The JOBS Act also took a cue from the wildly popular new type of project-funding websites, epitomized by kickerstarter.com.

Some provisions, such as the IPO-related ones, are effective immediately upon signing into law, and some, such as the elimination of general solicitation in Rule 506 offerings, crowdfunding and the new small issue exemption, will require adoption of related SEC rules.

JOBS Act Highlights

• Creates a New Category of "Emerging Growth Company"
  Emerging growth companies will be subject to less regulation both in the IPO process and as public reporting companies. This new regime brings regulatory relief to a much broader population of public companies than currently available to smaller reporting companies. Among other things, an emerging growth company will have reduced financial and compensation disclosure requirements, exemption from the SOX internal control audit requirement, greater freedom to "test the waters" with institutional investors in the IPO process, more freedom to allow investment bank analysts to publish and communicate information during the offering process and the privilege to file the IPO registration statement confidentially.
  
  
• Establishes a New Exemption from Registration for "Crowdfunding"
  A new exemption will allow issuers to sell securities to the public in amounts up to $1 million in any 12-month period. Sales must be through a broker-dealer or a new form of intermediary, the "funding portal". Issuers and intermediaries will have a number of disclosure and filing obligations which may significantly diminish the utility of this new offering concept. State law would be preempted from regulation of the offering process.
  
  
• Eliminates General Solicitation in Certain Private Transactions
  In a major shift in the private placement world, issuers will now be able to use general solicitation and advertising in private offerings under Rule 506 so long as all the purchasers in the offering are accredited investors. Similarly, resales in accordance with Rule 144A may be offered to persons other than qualified institutional buyers (QIBs) so long as QIBs are the only purchasers.
  
  
• Eases Section 12(g) Threshold for Triggering Public Company Reporting
  The JOBs Act reduces the risk companies will trigger periodic reporting company obligations under the Securities Exchange Act of 1934 by raising the shareholder of record threshold from 500 persons to either 2,000 persons or 500 persons who are not accredited investors. The act carves out from the shareholder of record count certain groups, including purchasers in a crowdfunding transaction and employees who receive securities under employee plans in exempt transactions.
  
  
• Authorizes a New Small Issue Exemption
  The JOBs Act requires the SEC to adopt a new exemption for offerings up to $50 million in any 12-month period that would be similar to existing and little used Regulation A, which allows for public offerings of equity, debt and convertible securities resulting in freely tradeable securities of the issuer. Unlike Regulation A, the new rules may require an issuer to provide periodic reports as determined by the SEC. State law would still apply except where the securities are offered or sold on a national securities exchange or to a qualified purchaser as defined by the SEC.

1. Public Offerings by "Emerging Growth Companies"
Emerging Growth Companies Defined

The JOBS Act creates a new category of issuers known as "emerging growth companies."  Emerging growth companies are those with annual gross revenues of less than $1 billion (as indexed for inflation) during their most recently completed fiscal year. The JOBS Act is intended to facilitate public offerings by emerging growth companies by exempting them from several provisions of the Securities Act of 1933 and its regulations. An emerging growth company will retain that status until the earliest of:

• The first fiscal year after its annual revenues exceed $1 billion;
• The first fiscal year after the fifth anniversary of its IPO;
• The date on which the company has issued more than $1 billion in non-convertible debt during the previous three-year period; and
• The first fiscal year in which the company has a public float of at least $700 million.

Financial and Audit Requirements

Under the JOBS Act, emerging growth companies are subject to scaled financial disclosure requirements.  Pursuant to these scaled requirements, emerging growth companies may:

• Provide only two rather than three years of audited financial statements in their IPO Registration Statement;
• Provide selected financial data only for periods no earlier than those included in the IPO Registration Statement in all SEC filings, rather than the five years of selected financial data normally required;
• Delay compliance with new or revised accounting standards until they are made applicable to private companies; and
• Be exempted from compliance with Section 404(b) of the Sarbanes-Oxley Act, which requires companies to receive an outside auditor's attestation regarding the issuer's internal controls.

Offering Requirements

In addition, during the IPO offering process, emerging growth companies are exempt from:

• Restrictions on analyst research prior to and immediately after the IPO, even from an investment bank that is underwriting the IPO;
• Certain restrictions on communications to institutional investors before filing the IPO registration statement; and
• The requirement initially to publicly file IPO Registration Statements. Emerging growth companies can confidentially file draft Registration Statements and any amendments with the SEC. Public filings of the draft documents must be made at least 21 days prior to commencement of the IPO "road show."

Other Public Company Requirements

Emerging growth companies are also exempt from other ongoing obligations of most public companies, such as:

• The requirements under Section 14(i) of the Exchange Act and Section 953(b)(1) of the Dodd-Frank Act to disclose executive compensation information on pay-for-performance and the ratio of CEO to median employee compensation;
• Certain other executive compensation disclosure requirements, such as the compensation discussion and analysis, under Item 402 of Regulation S-K; and
• The requirements under Sections 14A(a) and (b) of the Exchange Act to hold advisory votes on executive compensation and golden parachute payments.

2. Crowdfunding

New Exemption Authorized

In addition, the JOBS Act authorizes a new form of exempt financing known as crowdfunding.  Crowdfunding is the sale of equity to a relatively large number of investors in small increments.  As we described in our update in early February 2012, the JOBS Act provides for a new, non-exclusive exemption under Section 4 of the Securities Act of 1933 from the registration requirements of Section 5 of the Securities Act for transactions involving the offer or sale of securities, when:

• The aggregate amount sold to any investor by an issuer, including in reliance on this new exemption within the preceding 12-month period, does not exceed:
  •  The greater of (a) $2,000 or (b) 5 percent of such investor's annual income or net worth, if either the annual income or net worth of the investor is less than $100,000; and
  • 10 percent of the investor's annual income or net worth, not to exceed a maximum aggregate sold of $100,000, if either the annual income or net worth of the investor is equal to or exceeds $100,000;
• The aggregate amount that may be sold in reliance on the exemption within a 12-month period is limited to $1,000,000; and
• Securities are sold through:
  • A registered broker-dealer, or
  • A "funding portal," which is an individual or entity engaged solely as an intermediary in exempt crowdfunding securities transactions that does not offer advice or recommendations or solicit sales and does not compensate employees or other persons based on securities sales.

Transaction Requirements

The JOBS Act also provides for a new Section 4(6) of the Securities Act, which sets forth additional requirements for a transaction to qualify for the exemption.  The final version of the JOBS Act requires the use of an intermediary broker or a funding portal. Although the crowdfunding intermediary cannot offer investment advice, it may accept compensation for its services in a crowdfunding offering. Of particular note is that a crowdfunding intermediary will not be required to register as a broker or dealer under the Securities Exchange Act of 1934 or state law in connection with a transaction exempt under Section 4(6).

The intermediary must:

• Register with the SEC as a broker or funding portal;
• Register with applicable self-regulatory organizations;
• Provide risk information to investors;
• Ensure that each investor reviews investor-education information, understands the risk of losing the entire investment and can bear such a loss; and answers questions demonstrating an understanding of the level of risk;
• Take measures to reduce the risk of fraud, including obtaining a background and securities enforcement regulatory history check on each officer, director, and person holding more than 20 percent of the outstanding equity of every issuer whose securities are offered by such person;
• Not later than 21 days prior to the first day on which securities are sold to any investor (or such other period as the SEC may establish), make available to the SEC and to potential investors any information provided by the issuer to investors;
• Ensure that all offering proceeds are only provided to the issuer when the aggregate capital raised from all investors is equal to or greater than a target offering amount, and allow all investors to cancel their commitments to invest, as the SEC determines appropriate;
• Ensure that no investor in a 12-month period has purchased securities in excess of the aggregate limit for all issuers conducting crowdfunding offerings;
• Take steps to protect the privacy of information collected from investors;
• Not compensate promoters, finders, or lead generators for providing the intermediary with personal identifying information of any potential investor;
• Prohibit its directors, officers, or partners (or any person occupying a similar status or performing a similar function) from having any financial interest in an issuer using its services; and
• Meet such other requirements as the SEC prescribes.

The issuer must:

• File with the Commission and provide to investors and the relevant broker or funding portal, and make available to potential investors, information about the issuer, including its address, officers, directors and principal stockholders, a description of its business plan and financial condition, and its tax returns;
• Provide, for offerings that, together with all other offerings of the issuer under section 4(6) within the preceding 12-month period, have, in the aggregate, target offering amounts of—
• $100,000 or less—(I) the income tax returns filed by the issuer for the most recently completed year (if any); and (II) financial statements of the issuer certified by the principal executive officer of the issuer;
• More than $100,000, but not more than $500,000—financial statements reviewed by a public accountant who is independent of the issuer, using professional standards and procedures for such review or standards and procedures established by the SEC; and
• More than $500,000—audited financial statements;
• Disclose the stated purpose and intended use of the proceeds of the offering sought by the issuer with respect to the target offering amount, deadline to reach the amount, and regular updates regarding the progress of meeting the target;
• Disclose the price to the public of the securities or the method for determining the price;
• Disclose the ownership and capital structure of the issuer;
• Disclose such other information as the SEC prescribes for the protection of investors and in the public interest;
• Not advertise the terms of the offering, except for notices which direct investors to the funding portal or broker;
• Not compensate or commit to compensate, directly or indirectly, any person to promote its offerings through communication channels provided by a broker or funding portal, without taking such steps as the SEC requires to ensure that such person clearly discloses the receipt, past or prospective, of such compensation, upon each instance of such promotional communication;
• Not less than annually, file with the SEC and provide to investors reports of the results of operations and financial statements of the issuer, as the SEC determines appropriate; and
• Comply with any other requirements as the SEC prescribes, for the protection of investors and in the public interest.

Restriction on Resale

The JOBS Act restricts the resale of securities acquired under this new exemption. Purchasers of such securities may not transfer them for a period of one year unless they are transferred to the issuer or an accredited investor.

Preemption of State Law

Securities sold pursuant to the crowdfunding provisions are "covered securities" under the National Securities Markets Improvement Act of 1996 and are therefore exempt from most state Blue Sky Law requirements.

Exchange Act Registration

The JOBS Act provides that securities acquired pursuant to Section 4(6) are not considered to be "held of record," which prevents them from potentially triggering the registration requirements of Section 12(g) of the Exchange Act.

Limitations

As noted above, the final version of the JOBS Act contains amendments added in the Senate that potentially negate the many of the liberalizing effects of the crowdfunding provisions. We note that:

• Crowdfunding offerings must be made through a registered intermediary, which in addition to creating new opportunities for broker-dealers and portal sites, may create an additional burden for issuers. 
• The registered intermediaries have significant obligations to reduce the risks to investors, many of which will have to be promulgated by the SEC. These duties will increase the cost of crowdfunding offerings and limit the companies with which registered intermediaries will work.
• At least annually, issuers are required to provide to investors and file with the SEC financial statements, as the SEC deems appropriate. 
• The SEC is required to issue rules as it deems necessary or appropriate to carry out the crowdfunding provisions of the JOBS Act. 

SEC Chairwoman Mary Shapiro has expressed deep skepticism about crowdfunding. Therefore, we can expect that the SEC rules promulgated under the act will likely tighten the requirements for issuers and registered intermediaries that intend to engage in crowdfunding. Whether or not this limits the ability of crowdfunding to live up to its potential will be seen over the next several years.

3. General Solicitation in Private Offerings

The JOBS Act requires that the SEC revise its prohibition against general solicitation of investors in connection with private placements under Rule 506 of Regulation D if all the potential investors are accredited investors. In addition, the SEC must revise Rule 144A to permit general solicitation and general advertising. This change has major implications for how investors may be attracted to a private offering and jettisons one of the longstanding pillars of a private placement—the manner of offering or non-public nature of the offering.

4. Exchange Act 12(g) Registration

The JOBS Act also contains provisions that increase the number stockholders a company may have prior to the time it is required to register under the Exchange Act. Previously, a company with assets exceeding $10 million was required to register under the Exchange Act within 120 days after the last day of the first fiscal year in which it had 500 holders of a class of an equity security. The JOBS Act increases the number of equity holders of record to either 2,000 persons, or 500 persons who are not accredited investors. In addition, the act provides that securities held by persons who received the securities under an employee compensation plan in transactions exempt from registration or in a crowdfunding transaction as noted above do not count towards the limit. 

This is a significant reform. Previously, well-known companies such as Facebook were forced to register earlier than intended because they granted stock options to more than 750 employees. Less well-known issuers also frequently struggle with the requirements and must limit their option grants rather than trigger the registration requirement. This new provision should prevent foot faults and remove some stress from human resource and legal departments.

5. New Small Issue Offering Exemption

The JOBS Act also provides for a new offering exemption under Section 3(b) of the Securities Act with the following characteristics:

• The aggregate offering amount of all securities offered and sold within the prior 12-month period in reliance on the exemption can't exceed $50 million;
• The securities may be offered and sold publicly;
• The securities offered will be freely tradeable;
• The issuer may solicit interest in the offering prior to filing any offering statement, in accordance with SEC regulations;
• The issuer must file audited financial statements annually;
• The securities must be equity securities, debt securities, or debt securities convertible or exchangeable to equity interests, including any guarantees of such securities; and
• The offering will be subject to such restrictions as the SEC may determine are necessary, such as (i) a requirement to electronically file and distribute to prospective investors an offering statement that complies with SEC requirements; and (ii) a disqualification of bad actors similar to other exempt transactions.

The JOBS Act authorizes the SEC to require an issuer of a class of securities issued under this new Section 3(b) exemption to file periodic disclosures regarding the issuer. Securities sold pursuant to this new exemption are "covered securities" under the National Securities Markets Improvement Act of 1996 and are therefore exempt from most state Blue Sky Law requirements, so long as such securities are offered or sold on a national securities exchange or offered or sold to a qualified purchaser.

Conclusion

As with any legislation that significantly modifies the current regulatory scheme, views span the spectrum.  Some commentators have argued that the JOBS Act will destroy important investor protections and, therefore, weaken the capital markets.  Others have applauded this legislation as a bold act by the president and Congress that will reduce the cost of capital, spur economic growth, and aid job creation.  We think the truth lies somewhere in between these extremes. 

Properly implemented by the SEC and used by issuers, the JOBS Act will enable small startups to reach many new potential investors. It will allow private companies to reward employees with equity and conduct financing rounds without fear of prematurely triggering registration requirements. It may also reduce the financial costs and administrative burdens of going public, thus encouraging companies to conduct IPOs earlier. We look forward to the SEC's implementing regulations and will provide updates as they are proposed.